"It is typically characterised by strong, compelling, logic. I loosely use the term 'pyramid selling' to describe the activities of the City but you explain in crystal clear terms why this is so." commented Dr Vincent Cable MP to the author.

Sunday, 23 August 2009

Lord Mandelson stated that "The rewards (for bankers) need to be linked to risks. The problem is when excessive rewards start driving excessive risk taking." An enterprise has no choice: it must take a risk in the course of the business operations. This is in a nature of the economy. However it must always be a calculated commercial risk. It can be never an "excessive risk". Taking "excessive risk" is a legal wrong and, if it caused any damage, it must be pursued under civil law to obtain compensation from "excessive risk takers". It must also be investigated under criminal law. As Lord Mandelson effectively admitted bankers were rewarded for "excessive risk taking" since he was referring to the current crisis not some hypothetical situation. Hence, according to Lord Mandelson, bankers committed fraud. As explained in the seminal article on this blog, "The largest heist in history" the mechanism of this "excessive risk taking", i.e. fraud, was turning the global banking system into a giant pyramid scheme.

It is very refreshing and encouraging that a very senior British government official, effectively the Deputy of the Prime Minister, admitted that the financial community committed fraud from which it benefited. He was very clear that "taking excessive risk" was a euphemism for committing fraud. The taxpayers have all the right now to demand that the government will draw the conclusions from the Lord Mandelson's words: pursue a huge number of financiers on the charges of fraud and confiscate their wealth in order to compensate the taxpayers for the result of this fraud.

20 comments:

On a blog "housepricecrash.co.uk" at http://www.housepricecrash.co.uk/newsblog/2009/08/blog-according-to-lord-mandelson-bankers-are-fraudsters-24957.php, "drewster" criticised the article stating:

"Fraud is too broad a term. Pytel says risk is good but excessive risk is bad. However it's near impossible to draw a firm line - at what point does risk become excessive? Driving a car at 70mph is risky but legal; driving a car at 71mph is only slightly more risky, but it's illegal. It's even harder to draw a line with banks. All loans are risky, fundamentally."

drewster concluded in his following post: "This article is rather disingenuous."

In response:

1. I have never stated that risk is good. I simply imply that risk is inevitable part of life: we walk down stairs from the 10th floor, but we do not speed up our "trip" by taking a jump. If drewster does not see the fundamental difference in terms of risk taking between the first and the second option, I would not advise him to test both. (Although has he done so the whole world would have benefited, including drewster as, no doubt, he would have been awarded Darwin's award.)

2. A "1mph speed increase argument" is childish and silly. This way no speed would be considered as dangerous. It is also a counterpart of an argument: "- Do you not mind to spare a penny? No. - Can I have 1 million pounds in one penny coins?" (I bet copper itself would be worth more than a million pounds.)

3. However if drewster read the first seminal article of this blog "The largest heist in history" he would have realised that in terms of risk taking in banking there is a very clear line beyond which the risk is always excessive as it guarantees a collapse. This line is lending by banks with loan to deposit ratio of 100% or above.

4. Those who are more advanced in maths will understand further that:- drewster comparison to speed increase say from 70 to 71 mph is incompetent. This is a straight forward linear increase through arbitrary speed limit at 70mph. With lending, going across loan to deposit ratio of 100% is not linear: it is going from exponentially regressive cycles into exponentially progressive cycles that constitute a pyramid scheme and guarantee liquidity crunch.- therefore lending with loan to deposit ratio below 100% is like running downstairs: there could be arguable line when a reasonable commercial risk turns into excessive risk; lending with loan to deposit ratio above 100% is like jumping from the 10th floor – it is always an excessive risk (and this what was happening in the banking system, as it was turned into giant global pyramid scheme).

Therefore Lord Mandelson’s own assessment that bankers were “taking excessive risk” is confirmed by methodical analysis. Incidentally, setting up and operating pyramid schemes is criminal in any event, and this coincides with conclusions drawn from Lord Mandelson’s assessment.

Accusing anyone's work of being "disingenuous" without presenting solid justification is a rather a poor reflection on the accuser.

It appears that mander does not understand the difference between "wealth creation" and a "pyramid scheme", which is a fraud (i.e. crime) and is at the root of the current crisis. He seems to believe that the banking model effectively based on the same principles as Albanian pyramids of 1996 - 1997 could have functioned as a mechanism of wealth creation. It did not function in Albania then, it was not going to function here recently.

For more detailed explanation the author of this blog invites mander to read "The largest heist in history" - http://gregpytel.blogspot.com/2009/04/largest-heist-in-history.html

“Ok let's keep this polite. Telling other bloggers to jump off a tall building is rather mean. Here, have some ketchup to go with that chip on your shoulder.

Lord Mandelson is quoted by the BBC as saying: "The rewards (for bankers) need to be linked to risks. The problem is when excessive rewards start driving excessive risk taking."That's the entire quote, just twenty-one words.

Greg infers that Mandelson is referring to the present situation rather than to an abstract situation, which is a perfectly reasonable inference. However to infer that when Mandelson says "excessive risk taking", he means fraud or scam, is incorrect. Therefore Greg's title "Lord Mandelson concluded that bankers were scammers"is disingenuous.

Greg goes on to write "He was very clear that "taking excessive risk" was a euphemism for committing fraud." Umm, no, I don't see that in those twenty-one words. That's your interpretation, Greg. Disingenuous.”

In response:

1. I did not advise any other blogger to jump off a tall building. Indeed I wrote: “I have never stated that risk is good. I simply imply that risk is inevitable part of life: we walk down stairs from the 10th floor, but we do not speed up our "trip" by taking a jump. If drewster does not see the fundamental difference in terms of risk taking between the first and the second option, I would not advise him to test both.” So to make it clear: I actually discouraged from jumping off a tall building.

2. I do not know what Lord Mandelson meant exactly when he said what he said as I am not Lord Mandelson. I also think that drewster is not a nickname of Lord Mandelson on the web. However, in any event, “excessive risk taking” is a civil wrong, or even a crime, especially when “excessive risk” was taken for personal gains. (Lord Mandelson stated “excessive rewards start driving excessive risk taking”.) It is a fair comment that if Lord Mandelson believed that excessive rewards drove excessive risk taking (and such fact happened, which is now widely acknowledged) then he implied, albeit very diplomatically, that bankers committed fraud (i.e. “excessive risk taking” was a euphemism for committing fraud).

3. drewster is clearly not a specialist in logic or semantics (incidentally I have some professional appreciation of both). The fact that within his intellectual confines he does not agree with my conclusion is one issue. To call it “disingenuous” is basically a reflection of drewster character.

4. I am more than happy to publish any corrections/clarification by Lord Mandelson or withdraw the article at his request. I believe that at present my article is a fair comment upon Lord Mandelson’s views.

The answer is in Point 4 of the comment immediately above. I only add that if I am not asked by Lord Mandelson to withdraw this article (or publish any correction or clarification) this will be an indication that my comments are fair. In order not to let this be a vacuous comment, readers (especially critical ones) are encouraged to bring my article to the attention of Lord Mandelson.

No he doesn't imply that at all. Excessive risk taking (by bankers) doesn't equal fraud, except in your personal definitions of "excessive" and "risk", definitions which are specific to the issues you raise in your blog. Greg, your blog in general makes some fine points. However sometimes when you have a hammer, everything looks like a nail. Your hammer is the greater-than-100% loan-to-deposit ratio. Mandelson's quote looks like a nail to you, but it isn't.

Many of the bankers who took "excessive" risks (and received "excessive" bonuses) did so in areas unconnected to the loan-to-deposit ratios. When local bank loan officers were meeting their monthly mortgage sales targets by advising unqualified applicants to try a self-cert mortgage, they had no view on the big picture (the LTD ratio). However by meeting their sales targets they collected their commission. At the other end of the scale, when investment bankers were slicing and dicing subprime mortgage debt and repackaging it, most of them had no view on the big picture. They just sold the repackaged debt and collected the commission.

It could be argues that all these individuals took excessive risks, but is it fraud? If they genuinely believed their (flawed) models then is it fraud?

Let us leave readers to make their mind up on my and your arguments. Ultimately Lord Mandelson is welcome to provide his final clarification and he is warmly invited to do so.

(I do not think you understand my reasoning in my blog articles: the effects of lending with loan to deposit ratio above 100% propagate through all aspects of finance. However, this may not be clear to many readers. Therefore I will publish an article on that. Genuinely thanks for bringing that to my attention.)

"22. drewster said... when investment bankers were slicing and dicing subprime mortgage debt and repackaging it, most of them had no view on the big picture. They just sold the repackaged debt and collected the commission.

If drewster is correct investment bankers were committing fraud (if they knew what was going on), or were criminally negligent or – if they were thick enough not to understand the big picture of their actions, which frankly was pretty basic – people who put them into the position of investment bankers were fraudsters (using these guys as tools) or were criminally negligent as they appointed such dummies as investment bankers.

The picture is quite clear: if your house got burgled someone were to blame I suppose.

PS. drewster, if your assessment of investment bankers is correct, they are cretins beyond the wildest estimates. These things are trivial to even any half intelligent person of very little, if any, formal education.

“Politicians have praised the wealth creation of the bankers (house price speculation) before the crises. I am not going to go in detail and define wealth creation but just to remind every one of the creation of unquantifiable of 600 $ trillions of credit default swaps that have supported irrealistic wealth creation.”

In my view politicians and regulators are part of the same team that led to this crisis. This $600 trillion reflects – in massive extent – a bogus wealth that does not exist. This is a part of ballooned balance sheets that constitute a pyramid. To understand that: if a homeless gives you $2 million promise to pay you, he will not make you wealthy as you will never get it anyway.

“If an individual investment banker thinks up a brilliant plan to repackage subprime debt into tranches and sell it to different categories of client with different risk profiles, then he doesn't see the loan-to-deposit ratio. Relatively few people would have seen those figures, and even fewer would have realised the implications. Stupidity and greed alone don't constitute fraud.

My points are that:1) Excessive risk taking comes in many forms, not just exceeding the 100% loan-to-deposit ratio.2) Other than the specific case of exceeding the ratio, there is no clear definition of when a banker's risk is "excessive". When Nick Leeson brought down Barings bank in 1995, everyone was quick to denounce his excessive risk taking. However in 2009 when Goldman Sachs announced record profits from their trading team, they got a round of applause. It seems the only definition of "excessive" is when the bets go wrong.”

drewster, wake up, what I am writing about is pretty much a trivial stuff. So if these bankers could see this they should rot in jail and their wealth should get confiscated for sheer and unbelievable stupidity. Their genes should be taken off human pool.

Loan to deposit ratio above 100% is of course one of the risks. However exceeding loan to deposit ratio above 100% constitutes a pyramid scheme and is a sufficient condition for banking system collapse. Therefore exceeding loan to deposit ratio above 100% is always and “excessive risk” but it may not be the only one. (I hope you know very basics of logic.) It is trivial.

drewster if you really stand by your statment that "It seems the only definition of "excessive" is when the bets go wrong." then the financial system is run by complete idiots and thieves and must be disbanded. Despite my criticism I hope you are wrong on that.

I think we're coming closer to agreement on some points. Nevertheless....

"These things are trivial to even any half intelligent person of very little, if any, formal education."

Clearly they are not trivial, otherwise we wouldn't be in this mess! Also if it was so obvious there would be no need for your blog :)

Most bankers are pretty intelligent people. However many of them took out huge mortgages to buy expensive London houses, so they clearly expected the casino to remain open for a long time. If they were so clever then they would have sold up and gotten out long ago. (Maybe the truly clever ones did, leaving just the unintelligent ones behind.)

"The effects of lending with loan to deposit ratio above 100% propagate through all aspects of finance."

I agree entirely. That's precisely why it was hard for most bankers to see it. Only a handful made the decision to break that ceiling, but it affected all the rest in different ways.

Perhaps the best analogy is with Bernie Madoff. His clients didn't ask questions about the 15% annual returns; they all just thought they had backed a good horse. Similarly a lot of bankers didn't ask questions about where their money was coming from; they just thought that they were on the winning team. Was this fraud? For a handful yes, but not for most.”

and also

“Greg,

Final points. I understand the logic of necessary & sufficient conditions, yes. I agree that breaking the 100% ceiling alone is enough to cause runaway damage, of course. However I do not agree that it is trivial or obvious, or that it was widely known amongst bankers before Northern Rock collapsed. It certainly wasn't ever acknowledged in the media, except for rare lone voices.

Even those who knew the mathematics and the risks preferred to turn a blind eye. Politicians, bankers, investors, homeowners - they all ignored the risks as long as things were going well for them. It's hard for people to accept a theoretical future model, even if it is a mathematical certainty, when it flies in the face of what they are experiencing in the present and want they want to hear.

(Incidentally, for another example of this willful ignorance of mathematics, see peak oil.)”

It is great that we came from somewhat different positions and we agreed to great extent. My last highlights are:

1. For anyone who wants to work in high finance the stuff I am writing about on my blog should be trivial. In terms of maths it centres around exponential function characteristics (especially understanding its growth).

2. Lack of knowledge or intent may be an extenuating circumstance but, in itself, it does not absolve of civil and criminal responsibility. Pyramid purveyors in Albania believed in what they were doing in 1996 – 1997 In drewster’s sense they were not fraudsters or scammers. Similar to the City and Wall Street community they also believed in their new financial model and how clever they were and so on (“wealth creation” and all this kind of stuff) but a lot of them ended up in jail and their wealth got confiscated. I do not see any reason for treating the City and Wall Street financiers more leniently than their Albanian colleagues.

3. Banking is not about being “pretty intelligent” but possessing necessary skills (and knowledge of maths stuff that I am writing about is not even a starting point). People do not open dental practice, for example, based on the fact that they are “pretty intelligent” and can learn something “on the job”.

4. Those who wonder about the mainstream media coverage should reflect upon The Economist coverage of Enron. At the time when professional community knew that Enron was a dodgy company and Kenneth Lay was a scammer (but of course no one would have said it publicly for the fear of litigation), The Economist published the following article “The energetic messiah”

“By bending all the rules of the energy business, Kenneth Lay has turned Enron from a stodgy gas concern into a soaring new-economy company.”

“Enron is blazing a trail for its industry. After his speech, Mr Lay commented to an aide, with some surprise, that “some of these guys finally seem to get it.” Yes, she responded smugly, “they were even using some of our language!” Spend long enough around top Enron people and you feel you are in the midst of some sort of evangelical cult. In a sense, you are. Mr Lay, with his “passion for markets”, is the cult’s guru. His disciples are Enron’s managers, an intelligent, aggressive group of youngish professionals, all of whom “get it”. The “it” is the rise of market forces in the long-staid energy business.”

“Thanks to its take-no-prisoners attitude, and its highly sophisticated approach to managing risks, the firm has come to dominate America’s markets for wholesale gas and electricity. The results are breathtaking: the firm’s sales have leapt from $4.6 billion a decade ago to $40.1 billion last year, with most of that coming from trading energy. It is trying to repeat the trick in Europe and Japan.”

The Economist did not have to take a stand and challenge Enron as a scam at the time, but writing stuff like that was rather unbelievable.

Coming back to the coverage of the current crisis: if the “star” journalist and authority speaking in the media covering this crisis is a social anthropologist then you would not expect any analysis from her of any significant depth, would you?

I suggest reading three articles from my blog which are particularly relevant to this exchange:

Forgive me rather strong language used in exchange of arguments but unless you made your money directly in the financial sector (hence you can be a net beneficiary) and you are an average taxpayer, this financial scam (i.e. crisis) will costs you (according to the government data from the last autumn) at least £20,000 (i.e. £40,000 per working family). Most likely much more and will be repaid for a few generations. Therefore talking about economic recovery (like from the previous crises) has completely different meaning. Basically we hope that we are finishing extinguishing the fire of our home, but the process of rebuilding it and buying again our possessions has not yet begun. However our homes before they were set on fire they were burgled. (In this analogy the process of pyramid growth is burglary, literally, and setting on fire is a pyramid collapse.) Thus far the thieves got away with it and are enjoying the loot. This is not an emotive comment. This is reality: incidentally the same stuff happened in Albania in 1996 – 1997.

- if you are doing something and you take excessive risk, but you cannot gain from it personally (it is neutral or you can even lose) you behave recklessly; if there is any resulting damage you will have to pay compensation and depending on the type of activity (e.g. speeding on the road) and consequences you may end up with a criminal conviction);

- if you are doing something and you take excessive risk and you can gain from taking such risk but you cannot lose (or your loss is minimal compared to potential gains) it is a fraudulent behaviour; if there is any resulting damage you will have to pay compensation and you should end up with a criminal conviction.

The latter scenario describes very well the behaviour of a large number of bankers.

Wealth is only created by production.By owning media and political parties the bankers made us all believe that digits on mainframed computers is the 'new wealth' until humans discovered that paper isn't edible.Now it's time to put an end to this robbery and make sure that those responsible are locked up for good.

You mentioned that you have some professional appreciation of logic and semantics. However I believe it is the field of psychology which offers the most insight into the particular issue of bankers' culpability.

In 1963, the psychologist Stanley Milgram conducted a series of experiments which measured the willingness of study participants to obey an authority figure who instructed them to perform acts that conflicted with their personal conscience. [Read more at: http://en.wikipedia.org/wiki/Milgram_experiment]

Quoted from the Wikipedia article: "Ordinary people, simply doing their jobs, and without any particular hostility on their part, can become agents in a terrible destructive process. Moreover, even when the destructive effects of their work become patently clear, and they are asked to carry out actions incompatible with fundamental standards of morality, relatively few people have the resources needed to resist authority."

Does this not also apply to bankers? If hundreds of thousands of City workers were simply following orders issued by besuited successful wealthy senior bankers (a title which until recently was highly respected), then are they culpable?

It would be fascinating to repeat Milgram's experiments with bankers and bonuses, rather than with students and pain.

As with Enron, I agree that a small cadre of senior bankers are most likely guilty of fraud. However I don't think you (or Mandelson) can accuse all bankers of fraud. Many of them were just following orders, as in Milgram's seminal research.

Andrew, I agree that psychology offers a lot of insight. (Incidentally I also have some professional appreciation of social psychology: the Zimbardo's prisoner experiment and this kind of stuff.) But I would leave it to scientists, do-gooders and other people of more left leaning and compassionate nature than I am. I am a simple man supporting free market economy. Scams, like the current banking crisis, bring free market economy into disrepute. A lot of left oriented people say that capitalism failed. It did not. We were basically robbed by common fraudsters. I am in a mugged person's situation and, frankly, I want a mugger to be bunged up and get the stolen money back. And be able to go about my business without a fear that I will be robbed again.

Many Auschwitz camp guards also followed orders. Based on such parallel I have suggested we should have something similar to trials of German nazis after WW2. Starting with a trial modelled on the Nuremberg Trial, prosecuting the main perpetrators of this crisis and then moving to smaller fish and bring them to books.

At the end, even some of the minions of this banking scam could be spared from serving lengthy jail terms their wealth must be confiscated as a part of compensation to taxpayers for forced subsidies to the banks.

I think it might be useful to add a psychological dimension to this discussion.

There are weighty reasons to believe that chronic stress is far more prevalent than formerly believed.

In my article "Stress and Mind" (http://drgrandville.wordpress.com/stress-and-mind/) I am explaining how stress brings about much of the behavior found in top financial leaders including irresponsibility, greed, shortsightedness, weak judgment.

In my blog "Economic crisis – impaired brain function a major cause?" I am discussing why the behavior of top financial people seems to be more or less sociopathic and I am suggesting preventive measures for the future. Quote: "It seems reasonable to suggest, that brain dysfunction due to chronic stress has been a major reason why top political and financial leaders have developed and upheld a fraudulent financial system that was doomed to failure in the end."URL to the blog: http://drgrandville.wordpress.com/2008/10/21/financial-crisis-impaired-brain-function-a-major-cause/

I agree with you. My concerns are practical. I have always believed that criminals are psychologically flawed people (otherwise they would not be committing crimes). Maybe suffering from limited compassionate disposition I have never been arguing that muggers be allowed to walk free (despite the fact that I believe they must be sick people deserving medical attention). So whilst I agree that there is massive scope for psychological research into behaviour of bankers, I would not like to lose the focus on the facts that a lot of them are common criminals. And, from legal perspective they should be dealt with accordingly.

Having said that, seriously, I will support your work on psychological studies on the financial community. It is as important as studying psychology of socially disposessed muggers or shop-lifters from broken families background. However we should not forget that they all should be locked up. Let them share their experiences at HM B&B.

"You have managed to pick a very simple theory out of a very complicated situation and explain it very simply (to me anyway). This is very diffcult thing to do and a worthy achievement." - [a reader's comment]